1:55SearchAa454MBAD6110-A342Part 4 The Capital Budgeting Processfinancing a conveyor system having an 8 percent return with 6 percent debt and alsoevaluating a new product having an 11 percent return but financed with 12 percent com-mon stock. If projects and financing are matched in this way, the project with the lowerreturn would be accepted and the project with the higher return would be rejected. In real-ity, if stock and debt are sold in equal proportions, the average cost of financing would be9 percent (one-half debt at 6 percent and one-half stock at 12 percent). With a 9 percentaverage cost of financing, we would now reject the 8 percent conveyor system and acceptthe 11 percent new product. This would be a rational and consistent decision. Though aninvestment financed by low-cost debt might appear acceptable at first glance, the use ofdebt might increase the overall risk of the firm and eventually make all forms of financingmore expensive. Each project must be measured against the overall cost of funds to thefirm. We now consider cost of capital in a broader context.We can best understand how to determine the cost of capital by examining the capitalstructure of a hypothetical firm, the Baker Corporation, in Table 11-1. Note that the after-tax costs of the individual sources of financing are shown, then weights are assigned toeach, and finally a weighted average cost is determined. (The costs under considerationare those related to new funds that can be used for future financing, rather than historicalcosts.) In the remainder of the chapter, each of these procedural steps is examined.Table 11-1 Cost of capital-Baker Corporation(1)(2)(3)WeightedCost(aftertax) WeightsCostDebt ...Kd7.05%30%2.12%Preferred stockKp10.94101.09Common equity (retained earnings)Ke12.00607.20Weighted average cost of capitalK.10.41%Each element in the capital structure has an explicit, or opportunity, cost associatedwith it, herein referred to by the symbol K. These costs are directly related to the valu-ation concepts developed in the previous chapter. If we understand how a security isvalued, then there is little problem in determining its cost. The mathematics involvedin the cost of capital are not difficult. We begin our analysis with a consideration ofthe cost of debt.Cost of DebtThe cost of debt is measured by the interest rate at which a company can raise newcapital. For companies that do not issue bonds but simply borrow from a bank, thisrate will be the rate at which they can borrow from the bank. The more interesting casearises when the cost of debt is measured by the interest rate, or yield, paid to bond-holders. The simplest case would be a $1,000 bond paying $100 annual interest, thusproviding a 10 percent yield. The computation may be more difficult if the bond isBookmark added454ReaderContentsNotebookBookmarksFlashcardsIK 2:19scribd.com= S SCRIBDSearchQDownload Now21. Given the following information, calculate the weighted average cost of capital forHamilton Corp. Line up the calculations in the order shown in Table 11-1.Percent of capital structure:Debt...Preferred stock..Common equity.....30%1555Additional information:Bond coupon rate.....Bond yield to maturity...Dividend, expected common....Dividend, preferred..Price, common.Price, preferred...Flotation cost, preferred...Growth rate...Corporate tax rate..13%11%$3.00$10.00$50.00$98.00$5.508%30%S11-18

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WACC means weighted avg. of the cost of different sources. It simply can be computed as sum of…